Euro area prospects

Markets heaved a sigh of relief when the Dutch election failed to give Mr Wilders the government and when Mr Macron swept into the Presidency of France along with a Parliamentary majority. It meant the euro was safe for a bit from parties and candidates who wished to break it up. We have been positive on European shares for some months, expecting a decent economic recovery whilst political risk reduces.

There remains the question of the Italian election. This important event is enveloped in more cloud than usual. We do not know when it will be, though it has to take place by the spring of next year. We do not know for sure what the electoral system will be given the Parliamentary arguments over the constitution and the results of the Italian referendum applying a veto to change. Nor can we be at all sure which parties might emerge the victors. On current polling the anti-euro, anti-establishment 5 Star Movement is a little ahead, but only on 28.5% of the vote. The centre left Democratic party is in second place on 24%. The right of centre parties have been splintered with the collapse in support for Mr Berlusconi. Forza Italia is on 11.5% and the Lega Nord on 14%. When the two leading parties only command around half the vote, and the top four only have 78% of the vote, the safest conclusion is to say there will have to be some sort of coalition and the outcome is difficult to predict. Last time the 5 Star party and the Democratic party were both on a little over 25% of the vote, but this translated into 297 seats for Democracy and 108 seats for 5 Star in the Chamber of Deputies.

The markets assume Italian politics will have little capacity for major change given the conflicting parties and their poll positions. The market also assumes even were 5 Star to emerge as the largest party and be able to lead or influence a government, they would be unable to make the constitutional changes necessary to hold a referendum and take Italy out of the euro. This judgement seems to be the most realistic given current information.

The German election is arguably more important. We know that it will take place on 24 September. On current polls Mrs Merkel’s party has a good lead. Given the relative strength of the German economy it seems likely that once again she will emerge as the leader of the largest minority party. It is true her vote in recent polls at 36% is well down on the 41.5% she achieved in the last Federal election. A few months ago the SPD challenge was strong, but that too has subsided, with the main challenger party now on 25%. This leaves a comfortable gap for the Chancellor. The combined share of the two main parties is quite low at 61%. The Greens and Die Linke on the left are taking 16% between them, largely at the expense of SPD, whilst the AFD anti Euro party is polling 10%, more at the expense of Mrs Merkel’s CDU.

Both main parties are very committed to further EU integration

The German polls point to continuing coalition government. The most likely outcome is a resumption of the so called grand coalition between centre left and centre right, between the CDU and the SPD. Mrs Merkel needs to raise her popularity sufficiently to avoid a left coalition of the SPD, Greens, and Die Linke gaining enough seats. She may also be able to work again with the Free Democrats who are polling better than in the last Federal election. Any analysis of likely German policy has to examine the SPD proposals as well as the CDU ones, as it seems likely one way or another that the SPD will have influence on the next government.

The main differences between Mrs Merkel and the SPD relate to economic policy. The CDU favour tax cuts to spend some of Germany’s surplus, whilst the SPD favour larger increases in public spending, especially public investment. Mrs Merkel has moved to close down disagreement over gay marriage by granting a vote in the current Parliament which went in favour of reform of the law to recognise it. Both main parties are very committed to further EU integration, and see German policy in the context of European policy. The differences again relate to spending and economic management. The SPD want to see a more centralised EU budget with more infrastructure spending at EU level, whilst the CDU are cautious about more EU spending as Germany will have to pay a substantial part of the bill. With the exit of the UK the German contribution is going up anyway.

We like many in the market assume reasonable continuity in Germany post the election. The main changes come from the German success in generating a surplus, and from the improving relationship with France under Mr Macron. If Mrs Merkel survives Germany will still be the voice in the EU for financial discipline. However, a fourth and maybe final victory for Mrs Merkel as Chancellor may also presage some modest fiscal relaxation in return for promises of reform from France and the countries struggling within the Eurozone.

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